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small business guide to income taxationWhen starting a small business, one of the most important decisions you will make up-front is how you’re going to structure and register it with the state and the federal government. How your business is structured will affect how you are categorized for income tax purposes, so having all the information and making an informed decision will save you any surprises when it comes to tax season, not to mention the cost of having to change the designation at a later date.

So how do you know which structure is right for you? Your business structure is determined by the type of organization you select and the number of owners within the business. We will focus here on the income tax aspects of the entity choice for small start-up businesses reviewing three common structures – sole proprietorships, general partnerships, and Limited Liability Companies (LLCs).

We will not consider the legal ramifications of the entity choice as you will want to consult with an attorney regarding the legal aspects of the different entities. We will also not consider other taxation issues such as sales, use or excise taxes, nor will we discuss the taxation rules of rental activities. Here’s a basic breakdown of the income tax characteristics of various small, non-corporate, business entities…

Sole Proprietorship

If you are the sole owner, registering as a sole proprietorship is one of the most simple and common ways to structure your business. In fact, you are automatically classified as being a sole proprietorship if you carry out business activities but are not registered as any other kind. This structure gives you complete control over decision making.

The taxation of sole proprietorships is relatively simple. In general, you file a Schedule C (or F if a farming activity) as part of your personal tax return filing to report the income and expenses of your business. For federal taxes, the business itself is not taxed separately, although state requirements may vary. In other words, the business does not file a separate federal income tax return. So, on your personal federal income tax return, the net profit reported from your business will be included as taxable income subject to income tax. The net profit of the business generally will also be subject to a separate tax called self-employment tax, which is basically the method a sole proprietor pays Social Security and Medicare taxes.

Sole proprietors are not considered employees of the business and are not allowed to take a salary or wage. Instead, they will take a draw from the business. The tax reported on their personal income tax return is based on the net profit of the company and not on the number of funds withdrawn from the business.

Partnerships

A partnership is the default choice if there are two or more people who own a business together. Each individual would contribute to the business on some level and share in the profits and losses, depending on the percentage of ownership as agreed upon in a formal or informal general agreement. There are different kinds of partnerships such as general partnerships and limited partnerships. We will focus here on the taxation of general partnerships.

Taxes for general partnerships work a little differently in that they have to consider multiple parties. Partnerships must file an Annual Information Return in order to report the business’s income, deductions, gains, and losses. However, the net profits are divided up between the partners based on their percentage of ownership as outlined in the partnership agreement. Each partner is issued a Schedule K-1 at year-end which reflects their portion of the results of the company. This is often referred to as a “pass-through” entity, where the business income passes through to each owner’s personal return. Therefore, generally, the partnership entity doesn’t pay income tax as a business. The income reported to a partner from a general partnership is reported as taxable income and is subject to self-employment tax on the partner’s personal income tax return.

Just like sole proprietors, partners are not considered employees of the business and are not allowed to take a salary. Instead, they take a draw from the business – usually, owners take draws in proportion to their ownership percentage of the business. Like sole proprietors, the partner is taxed on their share of the net profit of the general partnership, not on the dollar amount of draws taken from the business.

LLCs

Many small businesses select the Legal Liability Company (LLC) as a legal structure when setting up their small business. In general, LLCs are relatively easy to form and do not have many of the requirements of a business set up as a corporation. The owners of the LLC are called members, and the default taxation of LLCs depends on the number of members in the LLC.  An LLC with one member has a default tax classification of a sole proprietorship. An LLC with two or more members has a default tax classification of partnership.

LLCs also have the choice to be taxed as a C-Corporation or an S-corporation. The LLC will have to make a specific election and submit it to the IRS for approval prior to claiming that tax status. The pros and cons of the taxation of those entities is beyond the scope of today’s blog, so we will cover that topic in a future blog.

We hope this small business guide to income taxation for three different small business entity structures has helped you choose the structure that is right for you. If you’re unsure which business structure will work for you and how it will play out in your taxes, reach out to our team for a consultation and we can help walk you through your options within the framework tax considerations.